Treasury cuts pensions allowance to close tax loophole

Tax magnified

The government is set to introduce new restrictions on pensions tax relief to close a potential tax loophole created by the changes introduced in this year's Budget.

Budget proposals would allow people to withdraw their entire pension pots after they reach retirement age, including a tax-free amount equal to 25% of the pot. So for example, if you had a pot of £20,000, you could encash the whole thing and pay tax only on £15,000.

Critics soon pointed out that this could be exploited by people approaching retirement age, who could simply put their entire salary into a pension - thereby receiving tax relief top-ups from the government - only to withdraw it later and avoid paying tax on a significant portion compared to what they would pay if their salaries went into a typical bank account.

Find the best pension funds available on your selected pension platform

Tax-relief restrictions

In addition, people could then theoretically open a new pension and reinvest their money, withdrawing it later for another round of tax relief on 25% of it. This would potentially allow people to claim tax relief multiple times on the same money.

The government has now moved to close this loophole by introducing restrictions on how much tax relief people can receive after they receive their lump sum the first time.

In a paper published this week, the government said the annual limit for tax-free contributions to a pension - in other words, the money eligible for a tax top-up when paid into a pension fund - will fall from £40,000 to £10,000 for people who decide to take out more than their 25% lump sum.

This means that following their first withdrawal, savers will only receive tax relief on the first £10,000 they invest in a pension, instead of the usual upper limit of £40,000 per year.

Although this does leave a bit of wiggle room for exploitation, the government will likely be keeping a close eye on how savers behave.

Dave Roberts, senior consultant at HR specialist Towers Watson, says: "High earners who might otherwise do the most tax planning should think carefully before accessing more than their tax-free lump sum before retirement - this would seriously compromise their ability to contribute to pensions in the final years of their career."

This article was written for our sister website Money Observer

More about